If you are a “writer” of commodity options, you inherently have exposed and unlimited risk. However, it’s this risk potential that provides the capacity to reap rewards. Therefore, a savvy commodity option writer understands that managing risk is more important than reaping rewards. The trade setup below details a strategy to help protect short option positions with longer than a month until option expiration. In a follow-up, I will discuss a strategy to help protect short option positions with less than a month until option expiration. These strategies can be tailored to reach your short term objectives and long term goals.
Let’s first establish a naked short option strangle position. A strangle is a trading strategy to yield a profit on a market with a high probability that futures will expire within a range. A call option and a put option are sold outside of the trading range.
Strangle Example: Selling one October 2012 Gold 1750 call and one October 2012 Gold 1450 put for a credit of $900.
Below is a screen shot of the October 2012 Gold futures chart. The blue horizontal lines make up the current range, at 1642.4 and 1534.3. The green lines represent the “written” strike prices. The red circles are my mental stop losses at 1644.0 (6/6/12) and 1534.3 (5/16/12).
The margin requirement, $3,563 per spread at the time of this writing, is found using a SPAN analyzer. Keep in mind margin requirements fluctuate dynamically as the futures price changes.
Therefore, we are using $3,563 in margin to profit $900 with unlimited risk on this trade example.
Below is a screen shot of the risk involved with this strangle using a tool I employ daily. I’d be happy to discuss the risk graph in detail, but as you already know, there is unlimited risk involved (at either 1350 or 1850 in the October 2012 Gold futures market the risk of loss is almost $10,000).
Knowing this, we must protect the positions and limit the risk on extreme moves. I recommend purchasing a protective call and a put in the trading month prior to the month where the strangle strategy was implemented. By doing so, I accomplish three things to benefit the bottom line (and potentially ensure longevity):
- The protective call and put are less expensive closer to expiration so we reduce the total cost.
- The strike prices can be purchased closer to the “written” strike prices further reducing the risk.
- The margin requirement on the strangle with protection is less than a naked spread, therefore additional contracts can be traded.
If the September 2012 Gold 1750 call and September 2012 Gold 1450 put strikes are purchased as protection, the margin requirement is reduced to $1,561 as seen on the SPAN analyzer below. The margin requirement is less than half of the naked strangle above. So in fact you could execute an additional spread to collect additional premium still at a reduced margin rate. The value of the September 2012 1750 call and 1450 put are each $100. Overall, the collected premium would equal $700 (not including commissions and fees). If we executed two contracts, at the reduced margin requirement, the premium collected becomes $1,400 and so on.
Example: Selling one October 2012 Gold 1750 call and one 1450 put for a credit of $900 AND Buying one September 2012 Gold 1750 call and one 1450 put for a debit of $200.
As you can see above, the protective call and put have the same strike prices as the “written” call and put. In a scenario if the market rallies above the 1750 level and you are assigned the underlying futures contract in October, you can exercise your September 1750 call. While the two contracts will not offset each other, they will act like a hedge.
There are 25 days (at the time of this writing) until the September contract expires (8/28/12), leaving 25 days of unprotected risk. If the futures price remains constant, the value of the “written” call and put in October have little remaining premium. As seen in the Theoretical Option Price Calculator below are the hypothetically value of the 1750 call with 28 days until expiration with futures at 1605.5 (and the same volatility) is just $179. The 1450 put at the same time (again, with volatility the same) hypothetically is just $79.
You could liquidate the October spread at that time. The net result would be $700 (not including commissions and fees) – $258 (value remaining) = $442. If we traded two contracts because of the reduced margin requirements, the net result would be $884. However it’s not necessary to liquidate as the premium and margin should be minimal enough to hold the positions until expiration and collect the full premium of $700 (not including commissions and fees).
If your trading plan is to sell a strangle in November 2012 (serial month) for a credit, at this time, a protective call and a put in October would be relatively inexpensive with just 28 days until expiration. The options would double in protection for the remainder of October and for the November “written” contracts.
In addition, if we need to liquidate one side of the strangle due to a breakout, the protective options may be held and liquidated for a potential profit.
Rinse, lather, and repeat. Hopefully you find this advanced strategy beneficial for your commodity option selling. If you have any questions feel free to contact me directly at 800.993.9656.